Trade Deficit Definition
Causes and Effects
WRITTEN BY PAUL BOYCE | Updated 25 August 2021
Trade Deficit Definition
A trade deficit occurs when a nation imports more goods than it exports. In other words, a nation buys more from other countries, than it sells to them. For instance, the US had a trade deficit of $563 billion in the first nine months of 2019. This meant it was buying more goods from countries such as China, Japan, and from the EU, than they were buying from the US.
A trade deficit comes under the term ‘balance of trade’, which looks at how much a country imports versus exports. So a trade deficit is a negative balance, whilst a trade surplus is a positive balance.
- A trade deficit is where a country imports more than it exports.
- In classic economic theory, countries with a trade deficit will see its currency weaken, whilst those with a trade surplus will see its currency strengthen.
- Consistent trade deficits can negatively impact the domestic nation through lost jobs, deflation, and government finances.
Trade Deficit Meaning
A trade deficit means that one country is buying more from other countries than they are buying from it. This can be measured in a macro sense – so a trade deficit with all the other countries in the world. Or, it can be used to measure a direct deficit with a specific nation.
If we look at the US-China trade deficit in 2019, we find that the US imported $320 billion more goods from China than China did from the US. So what does that mean?
When a US company or customer buys Chinese goods, they get paid in US dollars. In turn, Chinese companies may stock these US dollars to fight against currency fluctuations. Alternatively, they may trade them in for Chinese Yuan. What this does is send a signal to the market that the US dollar is in lower demand, and the Chinese Yuan is in higher demand. Consequently, the US dollar would weaken and the Chinese Yuan would strengthen.
In reality, this has not happened for a number of reasons. Primarily, Chinese currency manipulation has prevented such market mechanisms from working as we would expect, but also because the Chinese are stockpiling US dollars rather than exchanging them in the foreign exchange market.
Under normal market conditions, we would expect the nation with a trade deficit to experience a weakening currency. In turn, this makes its exports cheaper, and its imports more expensive. To explain, a weakened currency means that the US dollar for example exchanges for less of other currencies. As a result, the US dollar will buy fewer goods.
Under normal market conditions, we would expect the following to occur:
The country with a trade deficit can buy fewer goods from those it has a deficit with. As a result, it buys fewer goods from them and relies more on domestic production. At the same time, demand increases from abroad due to goods now being cheaper as the exchange rate weakens.
The country with a trade surplus can buy more goods from those it has a surplus with. As a result, it buys more goods from them. At the same time, exporters will face difficulties as international demand declines due to higher costs.
Effects of Trade Deficit
The effects of a trade deficit can vary depending on a number of variables. Some of these may not occur due to policy decisions that have taken place to mitigate them. At the same time, there are also factors at play. For instance, the US is the reserve currency for many countries. In turn, this has allowed its trade deficit to have little impact on the dollar.
So when we are looking at these effects, these are considered under ordinary market conditions. There is no market manipulation, no use as a reserve currency, nor any other manipulation to the money supply.
1. Lower Prices
Usually, the reason a nation has a trade deficit is because it can buy products from abroad at a cheaper rate than it can produce at home. However, it may also be because other nations produce different types of products.
For instance, Brazil is known for its coffee production. There are fewer other countries that can compete on a cost effective basis, especially as Brazil has the perfect climate. Either way, it leads to cheaper goods coming into the country.
At the same time, it must be said that this may only be a short-term benefit. Under the assumption there is no currency manipulation, we would expect the currency exchange rate to weaken the domestic currency and thereby make goods more expensive in the long-run.
2. Boost to Exporters
When a nation buys goods from other countries, it pays them in its local currency. That currency is then either stored as a reserve currency, or they are exchanged for local domestic currency.
This sends a signal to the markets that demand is weakening, thereby weakening the currency of the nation with the trade deficit. This makes imports more expensive, but exports cheaper.
As foreign nations have a stronger currency in comparison, it is able to buy more goods. In turn, this can boost demand for the nations exporters.
If domestic firms are importing productive machinery, they are able to benefit from its gains. For instance, a specific printing machine may only be produced in Israel.
Therefore, a printing firm can either purchase the machine and lower its production costs, or purchase an older and more expensive version from domestic suppliers. So what happens as a result is that domestic firms can become more productive, increasing profits, and investment in the economy.
4. Foreign Direct Investment
When there is a persistent trade deficit with another country, it means domestic currency is flowing there. For instance US dollars are paid to Chinese exporters for their goods. In turn, the Chinese exporters can either exchange the money or keep it in reserve. Ultimately, as Milton Friedman once said, the money comes back again.
It either comes back through lower exchange rates, which make the domestic nations exporters more competitive. Or, through Foreign Direct Investment.
However, the main issue with such is that foreign nations may be able to collect a significant amount of currency. In turn, this may be used to buy and control large parts of the economy.
From a geopolitical point of view, this can present a security risk. For instance, China may well be able to buy large parts of the US economy with its stock of US reserve currency.
When a country has a trade deficit, it is essentially sending its currency abroad. This means that the domestic money supply is actually shrinking. In turn, it is possible to see some level of deflationary pressure. However, it will depend on monetary policy, the demand for debt, and the extent of the trade deficit.
To explain, the decline in the monetary supply may very well be counter-acted by an increase by the central bank, which may very well stave off some level of deflation. Furthermore, foreign direct investment into the country may also help fight off any deflationary pressures. However, it may occur under certain circumstances.
6. Impact on Employment
This could either mean a reallocation within the workforce, or the outsourcing of jobs. In goes without saying that when more goods are demanded from abroad instead of domestically, jobs also shift abroad. This is because demand for the domestic goods falls. So in the short term, this could cause some minor job losses.
In terms of how the market reacts will depend on the exchange rates. Nevertheless, it is likely that new employment opportunities will arise. As consumers benefit from lower-priced goods from abroad, they have more money to spend elsewhere. In turn, this opens up new opportunities for other domestic firms.
However, the issue with such is that the new jobs will not necessarily be suitable for the previously displaced workers. Furthermore, not all the expenditure will translate into an equal amount of lost jobs.
Nevertheless, in the long-term, the currency will work its way back. Either through the exchange rate mechanism, or, alternatively, through foreign direct investment.
Causes of Trade Deficit
1. Lower Tariffs / Trade Barriers
When government signs a new trade deal and reduces tariffs, it creates competition. Foreign imports become cheaper and much more competitive. As a result, consumers may switch to imported alternatives. They may be both cheaper and of higher quality.
2. Low Productivity
When a nation experiences low productivity growth in relation to others, it can find itself become less competitive. As other nations become more productive, they are able to produce goods at a lower cost.
In turn, it makes their goods cheaper compared to domestic suppliers. As a result, we can see a trade deficit develop as consumers shift towards cheaper and more productive importers.
3. Strong Currency
A strong currency is usually a sign of an equally strong economy. Often, we will see floods of foreign money come into what are referred to as ‘safe havens’.
So when a nation experiences some economic or political difficulties, it may experience some capital flight to more secure markets. For instance, the Asian financial crisis in 1997 saw large levels of investment into the US in order to protect investors capital.
So when a nation has a strong currency, it can buy more goods from other nations at a lower price. At the same time, its exports become more expensive. So there is an opposite reaction which comes together to create a trade deficit.
4. Reliance on Specific Exports
Some nations rely heavily on a limited number of specific exports. For instance, Russia, Norway, and Saudi Arabia all rely heavily on oil. So when the price of oil declines, it can have a negative impact on their trade balance.
This reliance on a specific import means that such nations are more prone to develop a trade deficit.
General FAQs on the Trade Deficit
A trade deficit is where a nation imports more than it exports. So this means a nation relies on other countries to produce goods and services for consumption.
If a country has a trade deficit, it may create a number of effects such as:
– Lower prices in the short term.
– Weakening currency in the long term.
– Exporters benefit in the long term from lower exchange rates.
– Productivity gains if the goods being imported are capital equipment as opposed to use for consumption.
– Foreign Direct Investment, as the money gets invested back again.